Investors Stand Corrected

As readers of this column know, I like it when the market falls. Don’t get me wrong, I don’t relish other people losing money, but when any asset class moves up dramatically without taking a breather, it makes me wary. Well, my anxieties have been addressed this week, as stocks opened the week with quite a tumble.

On Monday, the Dow Jones Industrial Average fell 237.44 points to 12743.44, a full 10% below its October 9th record close of 14164.53. The S&P 500 index fell 2.3% on Monday and by the end of the day, was down 10.1% from its October 9th record. The magical 10% pull-back is known as a “correction,” which is half-way to a full-fledged bear market, usually defined as a 20% drop.

Investors have been spoiled over the past five years, in that there has only been one correction—at the beginning of 2003, when the US was preparing to invade Iraq. Since then, there has certainly been upside and downside volatility, but we have not seen a decline of 10% and that is an aberration. Until the bull market of the nineties, corrections were more commonplace and investors actually expected them to come along.

According to quick research that I conducted on line, there have been over 40 corrections since World War II. (Ned Davis Research says that there have been 43, while Bespoke Investment Group counted 45—suffice to say that there have been a bunch of them!) What seems clear is that the duration of the pullbacks has shrunk over time. Since 1990, corrections have lasted an average of 88 days from an average of 146 days between 1945 and 2007. The number of days that expire between reaching a 10 percent decline and the low point of the slide also has shrunk, to 43 days from 68 days.

With the 10% move, many are preparing for the worst: a continued slide that would make 2007 the first losing year for investors since 2002. But is that likely? To understand, let’s take a look at the last five times the Dow fell 10% from its previous high (January, 2003; June, 2002; February, 2000; October, 1999; and August, 1998). In all but one case (June, 2002), the Dow was higher at both six and twelve months later. Of course, past performance is no indication of future success, but sometimes it is helpful to consult the history books to assuage frayed nerves.

What is abundantly clear is that markets are likely to be volatile in the future, so if you have lost sleep over your portfolio’s performance, it’s probably a good sign that you need to adjust your allocation to a less aggressive stance. Seasoned investors understand that it is imperative to understand how much risk they can tolerate and model their portfolios accordingly. In my experience, some of the worst investment decisions are made after investors overestimate their risk tolerance, then find themselves in a state of high anxiety and sell when markets move against them, often throwing away months or years of gains during one episode of panic selling. Indeed, that is a far more painful correction than the market’s 10% pullback. Just imagine how sellers on Monday felt on Tuesday after the big snap-back rally.